Gain the Professional Trader's Edge by Understanding Risk.

10/26/09

Thoughtful investing not only involves the pursuit of profits but also the careful consideration of risk. Making big returns as a result of taking outsized risk is not sustainable as a trading strategy.

When you hear people talk about banking huge investment returns, consider what level of risk they took to gain those returns. Over time, investors who expose themselves to extraordinary risk usually have a few tremendous losses that destroy all of the gain.

BIG RISKS USUALLY RESULT IN COMMENSURATE LOSSES

Take, for example, the story of Harry Macklowe. He spent his career becoming a billionaire from investing in real estate in New York. A year ago, Mr. Macklowe decided to double the size of his holdings in seven office towers in midtown Manhattan. So, he and his son borrowed $7 billion in short-term, high-interest debt after putting down only $50 million in cash.

Unfortunately for Mr. Macklowe, pushing out on the risk curve has placed all of his billions at risk, as the debt market has ceased to be liquid and he is now having trouble repaying the loans.

We have seen this story play out many times before, and it is a story you should attempt to avoid in your pursuit of profits from aggressive trading strategies.

RISK REDUCTION INCREASES PROFIT POTENTIAL

There are investors who have found ways to gain above-average profits while taking below-average risks. Warren Buffett is clearly an enduring example of this.